Commentary: Why the fund may be too volatile for the average investor

The answer depends on whether you have reason to believe that in casting your lot with Berkowitz and the Fairholme Fund
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you are getting the best large-cap value of the last 10 years, or the one that is nearly dead last in the category over the last three years.

Coming up with an answer – deciding if you think the long-term story outweighs the recent past – is an exercise that pits an investor’s head against their heart and gut.

To see why that is, we need to look at the twisted journey Berkowitz and his flagship fund have been on.

Berkowitz is a deep-value investor who focuses his attentions on a few issues, and who doesn’t like to let go once he has his hooks in them. In the fund, that plays out in one of the lowest turnover numbers in the business; in real life, that surfaces in Berkowitz waging proxy fights and being involved in lawsuits, something that most fund managers typically eschew but that the Fairholme founder pursues, seemingly because he’d rather not be proven wrong about one of his picks.

For most of the fund’s tenure – it was launched in 1999 – performance has been admirable. In the last 10 calendar years, the fund has finished in the top 25% of its large-cap value peer group eight times, according to Morningstar Inc.; it was in the top 10% of the peer group in five years and twice finished as the top performer in the category, including 2012 when the fund gained nearly 36%. In 2009, Berkowitz’s other chart-topping year, he was named Morningstar’s Domestic Stock Fund Manager of the Year; a year later, the Chicago-based research firm named him as the category’s “manager of the decade.”

And then the wheels fell off.

In 2011, Fairholme lost roughly 32.5%, ranking dead last in the category, at a time when the Standard & Poor’s Index was up a few points for the year. This wasn’t like 2008 – when the fund dropped about 30% but actually did better than most of its peers – or even 2003, when the fund ranked in the bottom 10% of its peer group despite a gain of nearly 24%.

This was a stunningly large loss in a year when it was pretty easy to come out in the black. Some $6.5 billion left the fund.

Berkowitz’s big bets – he has always run a tightly concentrated portfolio – were off, he was fighting with corporate boards, in the courts and with his co-managers, going through a stretch when he lost four highly regarded juniors in four years. (He now manages the fund solo.)

And then came 2012, and his big rebound, beating the S&P by nearly 20 full percentage points. It was impressive, though the three-year record won’t look good until 2011 is further in the rearview mirror.

When 2012 was over, Berkowitz closed the fund to new investors, saying he didn’t want the rush of cash that comes in when a fund tops the market, preferring to deal with a smaller, dedicated core of long-term holders who will ride out the market’s ups and downs.

The only one anticipating a rush, apparently, was Berkowitz himself. The 2011 hit hurt his reputation and investors weren’t ready to forgive or forget. Moreover, he waited to close the fund until after the post-January 1 crush of money movement typically ends. He might have pegged the moves on frothy market valuations, but didn’t.

Now he’s reopening the fund just as most value managers are confessing that record highs have indeed made it harder to find good values.

Of course, Berkowitz doesn’t need to be able to find many stocks that fit his mold; currently, American International Group
AIG, +0.28%
makes up roughly half of the portfolio, and about 70% of the fund is in three stocks. (Bank of America
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and Sears Holdings
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are the other two.)

As inviting as recent performance has been, investors are notoriously bad about timing their plunges into Fairholme; Morningstar shows the fund as having an annualized average gain of more than 11% over the last decade, but shows the average investor in the fund earning closer to 4%, meaning they are late to the feast and just in time for the famine. Berkowitz did not respond to requests for comment.

Unless you can ride out the binge-and-purge cycles on a fund this volatile – because the fund’s structure virtually ensures that results will be at the extremes of the peer group – Fairholme’s re-opening isn’t particularly tempting.

“We think the fund’s previously strong track record has been tarnished by a horrendous 2011 and we believe the fund incurs elevated risk through its holdings,” said Todd Rosenbluth of S&P Capital IQ. “We believe that investors looking for a concentrated fund have better alternatives.”

Added Steve Goldberg of Tweddell, Goldberg Investment Management in Silver Spring, Md.: “Berkowitz is great theater – he’s fun to watch – but the fund is just too risky for most investors. … The best thing he could have done for shareholders was stay closed for good, and the best thing most investors could do for themselves is to ignore that the fund is open again.”

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